The Blog

Don't Blame the Abundance of Oil

*Kamiar Mohaddes [2005] is a Senior Lecturer and Fellow in Economics at Girton College, University of Cambridge. He did a PhD in Economics, supported by a Gates Cambridge Scholarship. Picture credit: Wikipedia.

According to the 'Resource Curse' hypothesis, resource-rich countries perform poorly when compared to countries which are not endowed with oil, natural gas, minerals and other non-renewable resources. Therefore, resource abundance is believed to be an important determinant of economic failure, which implies that oil abundance is a curse and not a blessing. Empirical support for the resource curse was originally provided in a 1995 study by Sachs and Warner which showed the existence of a negative relationship between real GDP growth per capita and different measures of resource abundance, such as the ratio of resource exports to GDP. This finding is clearly paradoxical.

In the case of Iran, for instance, historical data shows that in terms of maintaining and sustaining GDP growth, oil income has been a blessing. But it has also been a curse in inducing excess inflation, exchange rate volatility and macro-economic inefficiencies, with adverse political and institutional implications. The quadrupling of oil prices in the 1970s and the Shah's policy of spending almost all of the increased revenues domestically substantially increased the country's dependence on oil income, which also happened to coincide with a much higher volatility of international oil prices.

Revolution, war and economic sanctions, through their impacts on oil production and exports have introduced further important sources of variation in Iran's oil revenues. As a result, the Iranian economy has been subject to unprecedented oil revenue volatility. Annual oil revenue volatility has risen from 35.5% per annum during 1960-1978, to 51.1% per annum during 1979-2010, as compared to oil price volatility which rose from 11.3% to 26.1% over the same periods.

Abundance vs volatility

So is the poor performance of resource-rich countries, when compared to countries which are not endowed with oil, due to the abundance of oil in itself or is the curse instead due to price volatility in global oil markets and production volatility due to political factors (such as wars and sanctions)? More importantly, is there a role for institutions and the government (in particular fiscal policy) in offsetting some of the negative growth effects due to the curse?

What do we know about the curse? Although early studies showed the existence of a negative relationship between real GDP per capita growth and resource/oil abundance, more recent evidence is not so clear cut. Firstly, the early studies used cross-country analysis that fails to take account of the different contexts in which countries exist, and this could bias the results. Secondly, the early analysis ignored the effects of oil revenue volatility on growth, which turns out to be important.

The data in fact reveals that oil abundance has a positive effect on both income levels and economic growth for major oil producers, thereby challenging the common view that oil abundance affects economic growth negatively. However, it also shows there is a positive relationship between the volatility in oil revenue and GDP growth volatility, and a clear negative relationship between real GDP per capita growth and its volatility. This suggests that volatility in oil prices and production is associated with higher volatility in GDP growth, which in turn has a negative effect on output growth. One possible explanation for this is that the uncertainty arising from oil price and production volatility might suppress the accumulation of physical capital by risk-averse investors.

What are the main results?

Using annual data on a sample of 17 major oil producers (Algeria, Bahrain, Ecuador, Indonesia, Iran, Iraq, Kuwait, Libya, Mexico, Norway, Nigeria, Oman, Qatar, Saudi Arabia, UAE, USA, and Venezuela) over the period 1961-2013 and appropriate econometric techniques that take into account all three key features of the panel (dynamics, heterogeneity and cross-sectional dependence), we have studied the long-term effects of oil revenue and its volatility on economic growth under varying institutional quality.

Our results suggest that:

1) there is a significant negative effect of oil revenue volatility on output growth;

2) higher growth rate of oil revenue significantly raises economic growth; and

3) better fiscal policy can offset some of the negative effects of oil revenue volatility.

Therefore, while abundance of oil in itself is growth-enhancing, the main problem in terms of long-term growth is the adverse effects of excess oil revenue volatility due to, for instance, large swings in government expenditure, some of which are due to changes in political preferences or the decision by the politicians to generate a short-term boom so as to keep the population happy (as was seen in the Gulf countries following the Arab Spring). Because revenues are highly volatile, their management needs appropriate institutions and political arrangements so that the domestic expenditures from oil revenues become less volatile.

Seen from this perspective, oil revenue can be both a blessing and a curse, and the overall outcome very much depends on the way the negative effects of oil revenue volatility are countered by the use of suitable policy mechanisms that smooth out the flow of government expenses over time.

Avoiding the consequences of volatility

So, what are the key policy recommendations? The undesirable consequences of oil revenue volatility can be avoided if resource-rich countries are able to improve the management of volatility in resource income by setting up forward-looking institutions such as Sovereign Wealth Funds (if they have substantial revenues from their exports), or adopting short-term mechanisms such as stabilisation funds with the aim of saving when commodity prices are high and spending accumulated revenues when prices are low.

Norway's experience suggests that it might be possible for other major oil exporters to avoid some of the undesirable consequences of oil revenue volatility within a democratic political system with good institutions and an accountable government. The Norwegian Government Pension Fund, which aims to manage petroleum revenues in the long term, is an example of how a stabilisation and sovereign wealth fund can help offset not only the volatility of oil revenues but also help to smooth out government expenditures.

The government can also intervene in the economy by increasing public capital expenditure when private investment is low, using proceeds from the stabilisation fund. Alternatively, the government can use these funds to increase both physical and human capital, by improving, for instance, the judicial system, property rights and human capital. This would increase the returns on investment with positive effects on capital accumulation, TFP [total factor productivity] and growth. Improving the functioning of financial markets is also a crucial step as this allows firms and households to insure against shocks, decreasing uncertainty and therefore mitigating the negative effects of volatility on investment and economic growth.